Compounded interest is one of the most misunderstood aspects of financing. However, it's easy to become an informed borrower once you understand how compounding interest works. If you are applying for a compound interest car loan, it's important to know how this type of interest works to make it easier to choose the best subprime auto lenders.
The Basics of Compounded Interest
Lenders charge interest to make a profit. While most of us know this, we may not know that different loan terms can impact how much interest we actually pay. Each compound car interest loan comes with a specific compounding period. You will pay more interest when interest compounds on a more frequent schedule.
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How Is Interest Compounded on a Car Loan?
There's a fairly simple formula for how to compound interest on a car loan. First, you need to know how much you owe on your loan, how often your interest compounds and the annual interest rate being charged. The general rule is that you will pay more interest on your loan if your interest compounds more often. Here's how the formula works for a compound interest car loan:
- Divide your annual interest rate by how many times your interest compounds annually. This will give you your "periodic rate."
- Next, add 1 to your periodic rate.
- Next, divide your annual interest rate by 365 for each day of the year. This will give you your daily rate.
- You will now raise the number that you get to the power of the number of days that your interest accrues before you're required to make your payment. If you pay your car loan every 30 days, you'll raise your period rate to the 30th power.
- It's now time to subtract 1 from the answer you got in the previous step. This provides you with your rate of interest.
- Finally, multiply the answer you get by the balance of your loan. This is the compounding interest on your auto loan.
Do car loans accrue interest daily? Yes, most car loans accrue interest every day. If you look at your balance regularly, you will notice that the amount you're paying toward your interest actually goes down each month as the amount being put toward your principal goes up.
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Why Is a 72-Month Car Loan Bad?
Many financial experts advise against car loans that go over 60 months because you're likely to pay a much higher interest rate. Many people get enticed by this idea when buying a car from even the best subprime auto lenders because it offers lower monthly payments. However, you can easily get trapped in a negative equity cycle with this option where it becomes very difficult to trade in your car without incurring even more debt. In addition, taking years to pay off your car loan could put you in a spot where you're paying for car repairs while still paying your monthly auto bill.
Once you've found the best subprime auto lenders for your auto loan, make sure you're going over the specifics of what the payment schedule for each loan period looks like to get a realistic perspective on what you're signing up for if you go over 60 months.
Paying more interest for the same car simply takes money out of your pocket by making your car more expensive than it needs to be. Keep in mind that interest is not considered a tax-deductible expense. When possible, try to choose the shortest auto loan that allows you to make reasonable monthly payments to own a car.
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Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.